Legal Commentary

I'm off tomorrow morning to Chicago, for the Midwestern Law & Economics Association Conference, where Lesley Wexler and I will be presenting our paper Passive Discrimination, co-authored with Jon Klick. Then I'm headed to a wedding, and then to a publisher's meeting. The upshot is I don't expect to post between now and next Wednesday, bailout or no bailout.

In the meantime, though, if you want to get a sense of what happens when financial contagion grips a highly interconnected credit market, read this article about what the Lehman bankruptcy wrought. Whatever your view of the Senate bill in particular or bailouts in general, do note that if nothing is done, the Lehman-induced liquidity spiral in the credit markets is possibly a mild version of what the bailout is meant to avoid. And note also that when credit markets seize up for more than a short period, the result shifts over to even healthy non-financial companies, which suddenly find that they can't borrow. This situation would absolutely be a market failure, not an example of markets working as they're supposed to (for an excellent discussion of the distinction, see this post by Andrew Samwick). As the early 1930s showed, the consequences of that situation can be dire. For the record, I don't think that Bernanke and Paulson are dumb enough to allow a repeat of the Depression-era deflation that Mellon and Hoover egged on, so I don't think we are likely to see another Great Depression even if no bill is passed. But, there's an awful lot of room between what we will have now if we dodge a financial collapse and the GD: between losing all four limbs and losing none lies a good deal of territory I personally would prefer to avoid.

One very smart lawyer wrote to me that he opposed Monday's bill because "I tend to think we want to see how things go before stepping in, and that a preemptive strike is a bad idea before we know what will work." This is an understandable sentiment, but not one with much relevance to the current situation. First, we have already seen "how things go before stepping in". Even if we just go back to the Bear Stearns rescue, that was months ago. Since then the government tried to avoid bailing out Fannie Mae and Freddie Mac and lost. It let Lehman go to prove a point. That worked out, ahem, poorly, and AIG came next. I don't think it's accurate to suggest that we are dealing in preemptive territory now. Second, this isn't a situation where one gets to make a do-over if we wait too long (see today's David Leonhardt article on this point).

Finally, I want to make one comment on the issue of the current Senate bill. I don't know all the details, but I've read that the bill includes all sorts of tax cuts as sweeteners for House members of one or the other party. Contrary to Jim Lehrer's -- yes, I'll say it -- wrongheaded insistence in last Friday's debate that the cost of a bailout means we need a fiscal contraction, basic Keynesian economics suggests that in the middle of a downturn it is reasonable to run a deficit. (In our case, that means a greater deficit than we're already running, which is a topic for a different day.) I don't know all the details of the tax cuts at issue, and it may be that some of them are a bad idea, or that others would be better. But the fact that there are such cuts (or, for that matter, spending increases) isn't per se a bad thing; on balance it's probably a good thing.

Ta-ta.